Rights Offering (Stock Issuance) Definition
Rights Offering takes place when a company offers additional stock shares for sale to its existing shareholders on a pro-rata basis. These additional shares of stocks are known as “subscription warrants”. Generally, the per share price of these stocks is set lower than the market price. These are generally transferable, and the shareholders may sell them in the open market. The purpose is for the company to raise additional funds.
A Little More on What is a Rights Offerings to Shareholders
In a rights offering, the existing shareholders get the opportunity to buy the additional shares in proportion to their existing holding (but at a lower price). However, it is put to the shareholders if they want to exercise this right or not. There is no obligation.
Two types of rights offerings are generally practiced by companies:
Direct Rights Offering – In a direct rights offering, the company only sells the number of exercised shares. If a right holder fails to exercise her option to purchase, there are no standby purchasers present in the system. Thus, the company only sells the same number of shares as needed by the existing shareholders who want to exercise the right. It may result in underfunding if a large number of the shareholders choose not to exercise the right.
Insured/standby rights offering – In standby rights offerings, the unexercised rights are offered to standby purchasers (commonly investment banks). These warrants are generally have a higher strike price than the warrants held by the shareholders. The purpose is to ensure the company gets its needed capital.
Companies generally issue subscription warrants to raise funds for repaying debts, purchasing equipment, acquiring another company, or some other expenses. They may use the rights offering when there is no other viable option for raising funds. It allows them to raise funds without paying the underwriting fees. The approval of the existing shareholders is not needed to issue these stocks.
Although rights offerings allow existing shareholders to buy stock at a discounted rate, it may increase the risk of dilution. It may also lead to a more concentrated investor positions.
It is not always a wise decision to issue these additional stocks to raise funds. It strictly depends on the situation in which the stocks are being issued by a company. Sometimes the cost involved in the process of filing the stocks is higher than its benefits.
References for Rights Offering
Academic Research on Rights Offerings
The impact of information release on stock price volatility and trading volume: The rights offering case, Bae, S. C., & Jo, H. (1999). Review of quantitative finance and accounting, 13(2), 153-169. This paper investigates if the information disseminated through rights offering announcements cause changes in price volatility and the trading volume of the underlying stock. The results advocate for the release of new information through offering announcements and also provide evidence of its impacts on price volatility and changes in underlying stock. These results indicate that knowledge dominates consensus.
Risk, Dividend Policy, and the Optimal Pricing of a Rights Offering: Comment, Levy, H., & Sarnat, M. (1971). Journal of Money, Credit and Banking, 3(4), 840-849. This article focuses on showing that the determination of the optimal subscription price and an allocation ratio of a rights issue can be explained as a straightforward problem in cost minimization. This is because, to secure additional equity through privileged subscription, an optimal combination of subscription price and allocation ratio must be found.
The allocation ratio decision in the underwritten rights offering, Hansen, R. S., Pinkerton, J. M., & Ma, T. (1984). Financial Review, 19(3), 66-66. This study explains a rights offering as an invitation to current shareholders to buy new additional shares in an organization. This issue provides shareholders with the right to purchase new shares at a discount compared to the market price later in the future. This study investigates some of the underlying reasons that may lead to the decision of the allocation ratio by an organization.
Earnings Management, Support, and Connected Transaction: Empirical Evidence from Listed Companies with Rights Offering [J], Shunlin, G. L. S. (2010). Finance & Economics, 2, 014. This paper investigates the relationship between connected transaction and support and earnings management using a sample of 373 listed companies possessing rights offering. The results indicate that holding shareholders support listed companies with a higher performance before the rights offering. They also suggest that connected transaction of purchase and sale is inversely correlated with the discretionary accruals and items below the line.
On the rightholders’ subscription to the underwritten rights offering, Hansen, R. S., Pinkerton, J. M., & Ma, T. (1986). Journal of Banking & Finance, 10(4), 595-604. This research investigates the typical and mostly overlooked occurrence of an undersubscribed rights offering. The research finds out that because of subscription costs, it is improper to assume that rights offering will be fully subscribed just because the subscription price is below the market. The research utilizes ordinary least square estimates, as well as Tobit, estimates to prove this subscription cost theory.
Bribe payments under regulatory decentralization: Evidence from rights offering regulations in China, Liu, Y., An, Y., & Zhang, J. (2016). Journal of Banking & Finance, 63, 61-75. This paper examines the reasons and methods by which the bribe payments of firms vary due to the interaction between firms and local public officials under the decentralized regulatory system for rights offering that was implemented in China before 2001. The results suggest that bribe payments are directly related to local governments’ control rights, the opportunity costs of refusal to pay bribes by firms, and also the seriousness of firms’ Jensen agency problems.
On Costs and Benefits of Rights Offering and Public Offering, Cheung, W., Lam, K., & Tam, L. (2006). Preliminary draft, Department of Finance and Business Economics, Faculty of Business Administration, University of Macau. This study investigates the costs and benefits of public offerings relative to rights offerings since other studies have indicated contradictory evidence in various markets. The results of this study show that the decision of a rights offering is found to be a less negative signal compared to the decision of a public offering. These findings are in tandem with the results for the US stock market.
Tests of the efficiency of the US rights offering market: An option pricing approach, Bae, S. C., & Levy, H. (1996). Review of Quantitative Finance and Accounting, 6(3), 259-276. This study analyzes the efficiency of the US market for stock purchase rights in an options framework where the prices of rights are examined concerning the probabilities of actually earning above-normal profits. The results from an ex-post hedging test indicate that the trading strategy based on the rights valuation model can differentiate between overpriced and underpriced rights to generate significant book profits.
Rights offering announcements and the efficiency of the Kuwaiti market, Alhashel, B. S. (2016). Applied Economics Letters, 23(17), 1192-1196. This paper tests the semi-strong form of efficient market hypothesis in the Kuwait Stock Exchange (KSE). It examines the behavior of stock prices during the dates of rights offering announcements to decide how long prices take to reflect the new information. While using a sample of 69 offerings and event study methodology, the paper concludes that prices incorporate new information within four days.
The adjustment of security prices to the release of stock dividend/rights offering information, Çadırcı, B. (1990). (Doctoral dissertation, Bilkent University). The article investigates the market adjustment to the release of stock rights offering information for the stocks listed in the IMKB First market during 1986-1989. It analyzes the adjustment of security prices in terms of a market model that considers market-related factors. The results suggest that the adjustment process is slow and the positive cumulative average abnormal returns are observed after the event date.
Rights Offering, Market Response and Investor’s Returns, Ming, H. D. R. (2011). Journal of Financial Research, 12, 013. This study investigates the extent of the effect of rights offering on the stock market by screening several samples. The study finds that following the listed rights offering, the stock prices show periodic characteristics and that the price effect is not wholly negative. The six approaches that affect stock prices all differ over time length, and among them, the price discount rate of the rights offering is always the most essential approach that affects stock prices.